AFG Venture Group Dispatches

Corporate advisory and consultancy in Australia, South East Asia and India.

Surprises for 2012 – Graham Boyd, Policy Strategist & Fund Manager, Gemini Group

Two thousand and eleven was the year big name investors were constantly wrong footed. Many saw their personal wealth as well as that of their clients dented as markets blindsided them. Many sought refuge in gold, but just as gold appeared to be a peerless safe haven, its value tumbled. When budget deficits seemed set to send bond yields higher in major markets such as the US and UK, bond yields fell. In other bond markets, notably the Eurozone, the reverse occurred – spreads widened to previously unimagined heights. Investing in asset markets for many became akin to a game of blind man’s bluff – nobody seemed inclined to break out in song, “I can see clearly now, the rain is gone, I can see all obstacles in my way. Gone are the dark clouds that had me blind…”

In equity markets, the performance during January is often said to set the tone for the year ahead. Meanwhile, as January gets off to a lively start, what potential surprises can we envisage that might lurk in waiting for the unwary investor? Note that these are not forecasts per say, but events to which some degree of probability attaches, and could catch many off guard. It is worth noting though that not all of these events are of the unhappy variety. However, as media reports tend to define the year, media reports are likely to highlight the negative. Just as misery loves company, the media loves misery. So certain of these events, even if they unfold, will not necessarily contextualise the headlines.

In an Asian context, two surprising twists on long-established nostrums are features of the economic context for the New Year. The first is that capital naturally flows from developed to emerging economies.  However, no less august an institution than the IMF has urged China to stand by in readiness to play a key role in stimulating the international economy should events in the Eurozone unfold so as to render this necessary. Significantly, the IMF has called upon China to engage not in monetary stimulation of its economy, as others from the US Fed to the UK BoE and the ECB have done, but instead to deploy a package of fiscal measures of about 3 percent of GDP to bolster the economy. China of course has a low overall budget deficit, of about 1.1 percent of GDP in 2011. All this takes place in a context in which policy makers have already expressed the hope that China will deploy some fraction of its massive reserves to bolster the resources of the European Financial Stability Facility. The economic morality play behind all this is somewhat strange – why should a country where the citizenry on average enjoys much lower living standards than their counterparts in Europe be called upon to in effect help protect the much higher living standards there?

Meanwhile, the second surprising twist is that as developed economies around the world struggle with diminished medium-term growth outlooks, a reappraisal is underway of the significance of Japan’s “lost decades” since 1990 in which growth to all intents and purposes ceased. However, visitors to Japan report being struck by the discrepancy between the despair they expect to encounter, and what they actually find when on the ground. A single statistic is sufficient to make the case – since the lost decades began life expectancy at birth of the Japanese has increased from 78.8 to 83 years. Perhaps the slower economy has led to a much diminished incidence of karoshi (death from overwork)? This is far too big a topic to be explored here, but what it may point towards is the inadequacy of GDP as a measure of overall economic welfare, or social welfare period. This impinges on the environmental discussion, which has at times addressed the issue of modifying GDP to account for environmental degradation and other welfare reducing outcomes which are either not counted within GDP or actually contribute towards a measured gain in GDP. In other words, something constructive appears to have been going on in Japan for some time now that is not being reflected in the economic statistics. Nevertheless, an absence of conventionally measured growth continues to pose challenges for stock market investors.

1. The reappearance of speculative bubbles, spurred on by monetary easing and ultra-low interest rates in important money centres. The billion dollar question though, is in which asset classes? Equities, property? It’s difficult to envisage bond yields falling much further in the UK and USA. For fund managers the name of the game is to spot incipient speculative bubbles and float the portfolio on them for as long as is prudent, and then sacrifice a modicum of performance by hoping to time the exit from the trade before the market becomes seriously overheated. Which is far easier said than done.

2. For some time now it has seemed that central banks could expand the monetary base with impunity, without exerting a material effect on inflation. Some attribute this to the existence of a liquidity trap. However, it has also been fairly standard doctrine for decades, backed by substantial empirical research, that a monetary shock tends to partly flow into output and partly into inflation. One does not have to subscribe to one of the extreme schools to see that it would not be entirely beyond the bounds of possibility if this relationship were to reassert itself, with surprises both in the form of stronger economic activity than expected, but also accompanied by higher rates of inflation than central banks would like or are tasked with maintaining.

3. China could experience a significant economic disruption. It never ceases to surprise me, the extent to which otherwise sophisticated investors and market analysts put their trust in some bureaucrat somewhere to provide them with the certainty the world lacks. Currently, there is a school that has a naive and touching belief that the managers of the Chinese economy are mercifully immune from the uncertainly that bedevils the rest of us, and will somehow adroitly steer the right path for that large and complex economy. But it is beyond anyone’s compass to do so. In the West, investors are always seeking out the company of the senior policy makers in vogue at that time to provide them a steer on the future, while the selfsame policy makers are seeking out the company of influential market advisors who, they hope, can provide them with greater clarity on the situation as viewed from the ground.

4. Will the rest of the world economy necessarily be seriously impaired though by a substantial economic slowdown in China? China after all runs what some view as a notorious current account surplus. China would likely try to export its way out of a slump. This would flood world markets with cheap goods; hardly an unwelcome development for consumers. The biggest surprise could be the yuan depreciating on world currency markets, not through policy intervention, but occasioned by market forces.

5. Currency markets might deliver a further surprise in the shape of a partial fix for the euro crisis by delivering an unexpectedly weak euro. This would provide relief for the GIPSI economies, and at the same time provide stimulus to the German economy that little needs it, with possible overheating occurring in that economy. This dynamic if it unfolds though won’t be manifest during the first half of the year; it is more probable that policy makers will first grapple with renewed recession in the Eurozone.

6. Africa could prove to be an unexpectedly dynamic economic performer. True, this would be less of a surprise than certain of the others mentioned here, as the stirrings of vitality in that blighted continent is already apparent to many with an ear to the ground there. The Economist ran a feature on rekindling economic dynamism in Africa last year (3 December). http://www.economist.com/node/21541015. But awareness of this current could become more mainstream.

7. One sometimes gets the sense that UK Prime Minister Cameron is itching to jettison his coalition partners and go it alone. He may well feel that he could win an election outright, and feel inclined, should the opportunity present itself, to return to the polls for a mandate to govern unchecked.

8. A major medical breakthrough. For some time now, healthcare stocks have languished in the lower decile of historic valuations. Drug manufacturers continue to warn of expiring patents and a paltry new drug pipeline. But can this situation persist? A great deal of human ingenuity is being devoted to curing the major ills of humanity, and sooner or later another breakthrough will be delivered. But will 2012 be the year of a major announcement though?

9. A solar panel on every roof? Not quite just yet, nevertheless as prices of solar panels tumble, and technological advances yield better productivity, solar panels themselves could become far more ubiquitous. Just as falling chip prices broadened the uptake of computers from a specialist interest to one no schoolchild could be without, so falling prices of solar panels could render solar panels the next big market phenomenon.

10. A plunge in commodity prices. Notwithstanding a bit of a retreat in 2011, this was from nevertheless exalted values. Commodity prices continue to defy gravity; could 2012 be the year the old cycle reasserts itself and they all tumble back down? In this context, a material economic slowdown in China would have repercussions for other BRICS economies such as Brazil, as well as commodity exporters such as Australia.

11. The shrinking of Japan’s current account surplus in 2011 to Y9.63tr a 44 percent decline on the level of the previous year, and the lowest for 15 years has prompted some to wonder whether the long appreciation of the Yen vis a vis the US dollar could finally be drawing to a close, and that the Yen may actually exhibit some uncharacteristic weakness in 2012. The decline in the current account surplus was partly the result of the trade balance shifting into deficit, with exports of Y62.72tr exceeded by imports of Y64.33tr. It is by now well known that it is a perilous endeavour to attempt to forecast currency movements on the basis of economic fundamentals, and in any case the trade position should improve in 2012 as it was depleted by the earthquake of 2011. But it is also clear that the strong yen is posing a challenge for exporters. Were the Yen to depreciate at all, it would render the already attractive carry trade of borrowing in yen to invest in high yielding emerging market and commodity currencies even more attractive, since borrowers would be able to make repayments in depreciated yen.

12. More untamed natural phenomena in the shape of earthquakes, violent storms, and heatwaves. But these, if they occur, are not investible phenomena in that they cannot be anticipated in time for investors to take profitable positions.

Not all of these events can occur concomitantly of course. For instance a slump in China and a surge in Chinese exports would likely be accompanied by a slump in commodity prices, but, equally, a faltering of Africa’s advance. And share prices of commodity orientated companies would also tumble, although others might rise, and falling commodity prices would also mollify the inflationary impulse from the monetary expansion.

About the Author

Graham Boyd is policy strategist and fund manager at Gemini Group. Prior to this he worked for several years as an economic adviser to the UK government, where he was Deputy Director, Industrial Economics, at the Department for Business.

Graham lead a team of economists and strategists focusing on business sectors and sustainable development, with a particular focus on energy and climate change. He was especially involved in the design and implementation of EU ETS. He has also previously managed funds with a macro and sectoral orientation, and been highly rated for his investment strategy and economics research in various posts on the sell-side of the investment banking industry.

Graham Boyd, February 2012